Types of Businesses Sole Proprietorship, Partnership, and Corporation—Advantages and Disadvantages

1. Types of BusinessesSole Proprietorship, Partnership, and Corporation—Advantages and Disadvantages

2. Businesses can be organized as any of the following: sole proprietorship, partnership, C corporation, S corporation, franchise, or cooperative. In the United States, most businesses are sole proprietorships; corporations generate the most income. Each form of business includes both costs and benefits.Costs and BenefitsIn business, retail, and accounting, a cost is the value of money that has been used to produce something—afterward, this money is not available for use anymore. Generally speaking, a benefit is something of value or usefulness. In economics, a cost is an alternative that is given up as a result of a decision. In economics, a benefit is a quantifiable amount of money, such as revenue, net cash flow, or net income. Other benefits might be nonmonetary. A sole proprietor, for example, might value the independence of making his or her own decisions.

3. A sole proprietorship is an unincorporated business owned by a lone individual. The sole proprietor pays taxes on the business through his or her personal tax returns. Approximately 73% of all businesses in the United States are sole proprietorships. • Costs • The owner has limited ways to raise capital. Potential investors in the business cannot buy stock (there is no stock), making investment difficult to define and document. • The owner has unlimited liability and can lose personal assets along with business assets. If there are employees, their mistakes may create liabilities for the business. On the other hand, a small unincorporated business has more creditworthiness than an incorporated business of similar size since the owner's personal assets will be added to those of the company for the purposes of assessing credit. Lenders are aware, however, that business owners can shift assets back and forth between personal property and the sole proprietorship. Therefore, lenders may require the owner to guarantee the loan personally, which means he or she must put up personal property as loan collateral. • There is greater difficulty in attracting skilled employees to a smaller business. Potential employees usually prefer larger companies that tend to be more stable and may offer greater benefits. • Benefits • Independence—the owner alone is responsible for all aspects of the business. • Efficiency in decision-making (no board of directors or stockholders involved). • Tax reporting to the IRS is relatively simple and inexpensive. • Minor children of the sole proprietor may be hired without paying payroll taxes, and, if the child earns $5000 or less, he or she pays no income taxes. • Healthcare reimbursement arrangements (HRAs), also known as IRC Section 105(b) plan, are available to the employees, spouses, and families of sole proprietors. This loophole in the tax laws allows an employer plan to reimburse employees for medical costs, including medical and dental insurance, deductibles, copayments, and other healthcare expenses. • If a home office is used, a portion of office expenses, property taxes, utilities, and vehicle expenses may be tax deductible. • The owner keeps all the profits.

4. The letters THE IHO could be the first letters of words representing benefits of sole proprietorships:

5. PartnershipsA partnership is a business owned jointly by two or more people. Although not legally required, partnership agreements are strongly recommended. Such an agreement documents how the business will be run, how profits will be dispensed, etc. Some partnerships may offer employees the possibility of becoming a partner as an incentive to be productive in their work. In general, there are three basic types of partnerships: 1) general partnerships, where everything is divided equally (profits, liability, and management duties) unless an alternative is agreed to and documented; 2) limited partnerships (also called partnerships with limited liability), which allow partners to have limited roles and limited liabilities and where partners often hire managers for short-term projects; and 3) joint ventures, which are similar to general partnerships except they usually exist only for a limited time period or to complete a specific project. A joint venture can also file with the state as an ongoing partnership.Taxation of a partnership "passes through" to the partners, meaning that the business itself is not taxed, but, rather, all partners report their shares of the partnership's income or loss on their personal tax returns. Partnership taxes may include income taxes, employment taxes, excise taxes, self-employment taxes, and estimated taxes.

6. Benefits • Partnerships are relatively easy and inexpensive to form. • Owners share commitment, decision-making, profits, and responsibilities; however, each partner can contribute a unique set of skills and expertise to the success of the business. • The incentive of becoming a partnership may attract highly motivated and qualified employees. • The tax advantage of a partnership over a corporation is that the owners are taxed only once—on their personal tax returns. • As with sole proprietorships, business decisions can be made efficiently, without involving shareholders, officers, and directors. • Laws concerning partnerships vary among states; however, the Uniform Partnership Act has been adopted in every state except Louisiana, which means partnership laws are generally uniform across the country. • Acquisition of capital can be easier in a partnership than in a corporation since individuals often receive better loan terms. Banks perceive loans to individuals to be less risky since personal assets can be used to secure a loan. In addition, limited partnerships allow investors to avoid the personal liabilities of general partners. • Costs • Owners face unlimited liabilities, not only for their own actions but also for the actions of their partners. • There is no "chain of command" in decision-making, which creates the potential for conflicts among partners. • By law, a partnership is dissolved whenever any partner retires, resigns (known as withdrawing), or dies. However, this situation can be avoided by drawing up a partnership agreement that stipulates how a business can continue if a partner retires, withdraws, or dies. • According to the Uniform Partnership Act, the existence of a partnership is dependent upon the owners. Ownership (partnership) cannot be transferred unless all other owners agree.

7. CooperativesA cooperative (co-op) is an organization owned and operated by people who use its services; they are designated as members, or user-owners. Profits and earnings of the co-op are distributed among the members. Members have voting rights to control the operation and direct the co-op through an elected board of directors and officers. Formation of a co-op begins when a group of people share a common need and develop a strategy to meet that need collectively. A co-op may incorporate, but it is not required to do so.The co-op is not taxed; rather, it receives a "pass-through" designation, with the members reporting the profits and losses on their personal income tax returns. Cooperatives are subject to the regulations of the IRS's Subchapter T Cooperatives tax code. Members file taxes by submitting Form 1099-PATR with their personal taxes.

8. Benefits (Advantages) versus Costs (Disadvantages) of Cooperatives • Benefits • Members receive reduced costs for products and/or services due to the economy of scale provided by the co-op. In addition, if there is an excess of funds at year's end, the money may be distributed to the members. • The members cannot incur personal liabilities from the actions of the co-op. • The democratic operation of the co-op allows all members to have an equal vote regarding how the business is run. • For certain types of co-ops, funding opportunities may exist through government-sponsored grants. • For an incorporated co-op, the taxation status is similar to a limited liability company (LLC) because surplus earnings are not taxed. Members pay taxes on any surplus distributions they receive. • Costs • Because of the democratic nature of the co-op structure, everyone likely will not be happy with all decisions made by the group and the decision-making process may be slow. • It can be difficult to attract large investments since every member's vote carries equal weight regardless of the size of each member's investment.

9. A franchise A franchise is a relationship between the owner of a trademark, service mark, trade name, or advertising symbol and an individual or group (the franchisee) that wants to use this identity as part of a business. The franchise sells the right to the franchisee to operate the business in a certain area. The franchise also controls the business relationship. • Benefits • The franchise may provide the resources (e.g., financing assistance, training, marketing, and management expertise) necessary to assure the franchisee's success. • The franchisee has exclusive rights to operate the business within a defined area. • Costs • The price of the franchise may be very high. • There is very limited flexibility on how to run the business.

10. Limited Liability Company (LLC)The limited liability company (LLC) is a cross between the limited liability feature of a corporation and the taxation and operational features of a partnership. The ownership of an LLC encompasses a broad range of choices—from individuals, to corporations, to other LLCs, and more options. LLC owners are "members," and profits and losses are "passed through" and reported by individual members on their personal tax returns—in a similar fashion to partnerships.

11. Taxation of an LLCThe federal government does not tax LLCs, but some states do. LLCs usually are not taxed, so LLC members pay federal taxes on their personal income tax filings; however, the federal government automatically categorizes certain LLCs as C corporations and taxes them accordingly. If an LLC is not designated automatically as a corporation, its members may choose to file with the IRS as either a partnership or a sole proprietor. Visit IRS.gov for further clarification on how to file as an LLC

12. Benefits • Liability for business losses or actions of the LLC do not apply to the personal assets of individual members of the LLC. Exceptions apply, such as tort actions by employees due to accidents. Tort is any wrongdoing not involving breach of contract for which a legal action for damages may be filed. • Perhaps the most significant benefit is the minimal amount of start-up expense and recordkeeping required. • There are few restrictions on profit sharing in contrast to partnerships, where profits must be evenly distributed. • Taxation is "passed-through" to individual members' returns, rather than the double taxation of C corporations, where both the corporation and shareholders are taxed. • Costs • The lifetime of an LLC may be limited to the participation of the original members. In many states, this means the business disbands when a member leaves the LLC; however, it may be possible to prevent dissolution by creating an operating agreement that provides for the departure of a member. • The entire net income of an LLC is subject to Medicare and Social Security taxes.

13. S Corporation • An S corporation, or S corp, is designated based on Subchapter S of Chapter 1 of the Internal Revenue Code. Filing as an S corp allows a business to avoid double taxation—once on the corporation profits and again on the shareholders. • To qualify as an S corp, the business must: • be a domestic corporation • have only allowable shareholders • include individuals, certain trusts, and estates • not include partnerships, corporations, or nonresident alien shareholders • have no more than 100 shareholders • have one class of stock (all shares must have same dividends and voting rights per share) • not be an ineligible corporation (e.g., certain financial institutions, insurance companies, and domestic international sales corporations) • To receive S corp designation, a corporation must first register as a C corporation in the state where it plans to become an S corporation. S corporations are "considered by law to be a unique entity, separate and apart from those who own it" (IRS code). Thus, as with C corporations, there is a limit on the financial liability of each shareholder. • The main difference from a C corporation is that with S corporations, profits and losses "pass through" to the shareholders' personal tax returns, and the business itself is not taxed. To prevent abuse of the lower corporate tax rate, individuals who work for the company must receive fair market value for their services. Otherwise, if a shareholder receives corporate earnings in lieu of wages, the IRS has the option to reclassify the corporate earnings as wages and tax those earnings at the higher personal income tax rate. • As is the case with C corporations, states vary in their recognition and regulations of S corporations.

14. Benefits • Lower taxation of the business owner is a significant feature of the S Corporation. The shareholder, who also is an employee, pays taxes on wages but also receives a dividend from the corporation for his stock, which is usually taxed at a lower rate. The corporation itself is not taxed because they "pass through" to the owners' income taxes. • The shareholders/employees can write off business expenses. • The shareholders are protected from liabilities incurred by the corporation. • Since up to 100 shareholders are permitted, there are more opportunities to raise capital. • Accounting rules can be simpler, compared to C corporations. • Costs • S corps are required to operate under strict processes, such as holding board of directors' and shareholders' meetings and keeping detailed records—similar to the demands on C corporations. • Compensation requirements include a careful accounting for the wages and distributions of shareholder employees. A shareholder is required to receive reasonable compensation for services rendered to the corporation, even if the corporation is not making a profit. • Shareholders will be taxed for income the corporation makes, even if they do not receive any of that income. Also, an S corporation can issue only one class of stock.

15. Corporations According to the IRS, there are four characteristics that define a corporation: limited liability in terms of personal assets, continuity of life, centralization of management, and the ability to transfer ownership interests. If you wish to have more than two of these characteristics, you will have to incorporate your business and operate as a corporation. C Corporations Regular corporations are called C corporations after Subchapter C in chapter 1 of the Internal Revenue Code. The identity of a corporation is separate from that of the shareholders who own it. This means that corporations, and not shareholders, are legally liable for any indebtedness and/or actions of the corporation. This does not mean, though, that individuals representing the corporation are immune from the consequences of illegal behavior. A corporation is formed in accordance with the laws of the state in which it is registered, and these laws vary from state to state. Since C corporations are the most complex (with costly administrative fees and complex tax and legal requirements) of the business entities, they tend to be large, established companies with many employees and with a relatively large flow of cash.

16. Benefits • C corporations can raise capital by selling shares of the business to prospective shareholders in exchange for money, property, or both. The initial sale of stock is often done when the business "goes public" through an initial public offering, known as an IPO. To justify the expense of setting up and registering a corporation, the business should have enough income or potential income to reap the benefits of a large entity. Such benefits could include the following: 1) capital to make large-scale investments; 2) qualifying for bank loans and lines of credit; and 3) achieving economies of scale through large purchases. • Limited liability. Corporations have limited liability, in that individual employees (including management) or shareholders are not personally liable for the actions or indebtedness of the corporation. • Corporate tax treatment. Corporations usually pay lower taxes, and only on the profits of the corporation. In addition, these taxes are completely separate from the taxes paid by individual owners of the corporation. Individuals would, however, pay personal taxes on bonuses, salaries, and dividends received from the corporation. • Not only is partial ownership attractive to employees, it also motivates employees to make the company successful. Another attraction—though not necessarily unique to C corporations—is employee benefits, such as health insurance and retirement plans, which are tax-deductible expenses for the corporation while adding to the employees' compensation. • The corporation has a "perpetual existence," compared with employees or shareholders who may leave the corporation.

17. Costs • Corporations are double-taxed; profits are taxed at the corporate level and again when distributed to shareholders as dividends. • Corporations are more expensive to establish and operate. • Complex regulations consume many resources in terms of business accounting, environmental regulations, taxation, employer-employee relations, etc. • The corporation is accountable to stockholders. Annual meetings are required, and major changes in the corporate structure or dividend policies require stockholder approval by vote.